What to do when a client has an undisclosed foreign account

Weighing the options requires a thorough understanding of risks.

CPAs often have clients with an interest in or signature authority
over a foreign account. The IRS has emphasized compliance in reporting
requirements for U.S. owners of foreign accounts, but many taxpayers
may still not know their responsibilities and liabilities. This
article outlines these responsibilities and liabilities and describes
current enforcement efforts.

DISCLOSURE RESPONSIBILITIES

A taxpayer who has an interest in or signature authority over certain
foreign accounts must inform the government of the existence of the
account each year by checking the box in Part III, line 7a, on
Schedule B, Interest and Ordinary Dividends, of the
taxpayer’s Form 1040, U.S. Individual Income Tax Return. The
taxpayer must also attach Form 8938, Statement of Specified
Foreign Financial Assets, providing details about the foreign
accounts if the account balances and the value of other foreign
financial assets total more than $50,000 on the last day of the year
or more than $75,000 at any time during the year for single filing
status. For married taxpayers filing jointly, the threshold amounts
are $100,000 and $150,000, respectively. Taxpayers with foreign
accounts with an aggregate value of more than $10,000 during the
calendar year must also file FinCEN (Financial Crimes Enforcement
Network) Form 114 (formerly TD F 90-22.1), Report of Foreign Bank
and Financial Accounts (FBAR). This form is filed
electronically with the Treasury Department’s BSA (Bank Secrecy Act)
E-Filing System (accessible at tinyurl.com/qo9apa) not later
than June 30. No extensions are available.

Over the past several years, many taxpayers with foreign accounts
have erroneously checked “no” on line 7a of Schedule B, Part III, and
have not filed Forms 8938 or FBARs as required. A taxpayer who signs a
return without disclosing the existence of a foreign account may well
have committed perjury, and hiding assets in an offshore account may
constitute tax fraud.

HOW DOES THE IRS FIND FOREIGN ACCOUNT OWNERS?

The U.S. Treasury and Justice departments have become aggressive in
going after foreign banks and other facilitators to get information
about U.S. account owners. The first major target that they had
success with was UBS in Switzerland, which ultimately turned over the
names of more than 4,000 U.S. taxpayers with hidden Swiss accounts.
UBS also agreed to pay a $780 million fine as a result of an
investigation and its guilty plea to helping Americans evade taxes.

Switzerland’s oldest bank, Wegelin & Co., paid $74 million in
fines, restitution, and forfeitures and agreed to cease operations as
a bank. More banks in Switzerland followed, and the program has been
extended to many other countries and areas, including Israel and the
Caribbean. As these banks enter into settlements with the U.S.
government, they often agree to hand over the names of their U.S. customers.

In August, the United States and Switzerland signed an agreement that
provides for fines in exchange for nonprosecution agreements for banks
that facilitated American tax evasion. As these banks enter into
settlements with the U.S. government, they, too, will hand over the
names of their U.S. customers.

Another recent development was the indictment of Edgar Paltzer, an
American-educated Swiss attorney who not only helped many Americans
evade taxes through foreign accounts but had control over and access
to many European bank vaults holding assets and valuables that were
being hidden from the government. He faces up to five years in prison,
but the sentence is expected to be less because he is cooperating with
authorities. The information Paltzer is providing gives the IRS a
better picture of the methods used to evade taxes by transferring cash
and assets to foreign accounts and locations.

Sensational stories of high-profile foreign account cases have caused
many taxpayers with foreign accounts to step forward under the IRS’s
Offshore Voluntary Disclosure Initiative (OVDI). As of December 2012,
the IRS had collected more than $5.5 billion in back taxes, interest,
and penalties from more than 39,000 taxpayers under the program, the
U.S. Government Accountability Office (GAO) reported (GAO Rep’t No. 13-318).

OPTIONS FOR TAXPAYERS WITH UNDISCLOSED FOREIGN ACCOUNTS

Taxpayers who have an unreported foreign account must decide which of
three actions to take: do nothing and hope for the best, make a quiet
disclosure or a new disclosure, or enter the OVDI.

Do nothing and hope for the best. This is,
obviously, a high-risk option. Treasury and Justice continue to hone
their skills not only in going after individuals who have foreign
accounts but also in securing names of U.S. account holders from
foreign banks. Nearly every FBAR matter that is resolved requires the
taxpayer to sit down with the IRS to answer questions. To the extent
that the Fifth Amendment right against self-incrimination is not
invoked, the IRS gets information at each of these meetings that can
help it find and prosecute those who helped Americans open foreign
accounts and hide income from the government. The facilitators, as
part of their own settlements, often turn over the names of U.S.
owners of hidden foreign accounts. Considering the increasing
likelihood that the IRS will eventually find foreign account owners,
stepping forward and doing something is likely preferable.

Quiet disclosures and new disclosures. With a
quiet disclosure, the taxpayer files amended income tax returns and
FBARs going back as far as the statute of limitation requires,
generally three or six years. The benefit of a quiet disclosure is
that the taxpayer is not coming forward under the OVDI, thereby
avoiding even the reduced penalties imposed under the program. In such
a case, the taxpayer merely amends his or her returns to bring them
into compliance with the law and completes the necessary FBARs. This
may have worked for many people over the last several years, but it is
becoming a high-risk tactic, too. Taxpayers who reported the income on
a foreign account but failed to file FBARs are likely to fare better
from a penalty perspective than those who did neither.

The GAO report cited above suggests that quiet disclosures have been
rampant. It determined that from 2003 to 2008, 10,595 taxpayers made
quiet disclosures. Of those, 3,386 taxpayers made late or amended
filings for multiple tax years—94 of them for all six years. The IRS
is also aware of the problem, though it had estimated a much smaller
number of quiet disclosures. The GAO recommended that the IRS begin to
look for these amended returns to better detect quiet disclosures and
impose penalties where warranted.

Among other things, the GAO said the IRS should explore options to
more effectively detect and pursue quiet disclosures and analyze
first-time offshore account reporting trends to catch people trying to
avoid paying what they owe.

First-time offshore account reporting, or a “new disclosure,” is
another tactic taxpayers have used. The taxpayer simply makes the
disclosure on a current return and hopes not to be discovered for
prior years. This has worked for some, in much the same way that quiet
disclosures have worked for others. The GAO noted that the number of
taxpayers checking the box on Schedule B that indicates the existence
of a foreign account has more than doubled from 2003 to 2010, to
515,635. Strikingly, the number of FBARs filed more than tripled to
618,134 from 2003 to 2011 and more than doubled between 2009 and 2010.

The IRS will likely begin to take a closer look at first-time FBAR
filers and at returns where line 7a of Schedule B is checked for the
first time. In addition, a much higher level of audit activity can be
expected where amended returns are filed that indicate the existence
of a foreign account.

The IRS OVDI. The IRS has had three iterations
of the OVDI. The first iteration offered the lowest level of penalty
(20%). The current version sets the penalty at 27.5%. Under the
program, the account owner must also agree to be taxed on the prior
eight years of income in the account rather than three or six.

Why would owners of foreign accounts step forward under the voluntary
program when they are virtually assured that in addition to eight
years of federal income tax on the account earnings, they will be
required to pay a 20% accuracy penalty on the amount of income tax
due, interest, and 27.5% of the highest account value as an additional
penalty? Under the voluntary program, the potential for criminal
prosecution is removed. In addition, outside the voluntary program,
the penalties can be far higher, as much as the greater of $100,000 or
50% of the highest account value for each violation. In most cases,
this larger penalty has been applied to the highest account value over
the last three or six years, depending on which statute of limitation
applies (see Internal Revenue Manual (IRM) Section 4.26.16.4.7(4)).
But see Zwerner, No. 1:13-cv-22082-CMA (S.D. Fla., complaint
filed 6/11/13), for a case where the government is attempting to
collect multiple-year maximum civil penalties in an FBAR matter.

The first step when a client desires to enter the voluntary program
is to write to the IRS Criminal Investigation Division (CID) to get
the client precleared to enter the program. A client whose bank has
already provided the IRS with the client’s information is not likely
to receive clearance. If the client is precleared to enter the
program, the next step is to amend the last eight years of income tax
returns to include any previously unreported income from the foreign
account.

These items must be submitted when disclosing a foreign account,
generally within 45 days after receiving a preclearance letter:

Copies of original returns (and amendments) filed for the years
covered by the voluntary disclosure.

Amended returns and certain tax return schedules for the years
covered by the voluntary disclosure.

A signed offshore voluntary disclosure letter with the necessary attachment.

A check for the tax, interest, and penalty computed on the account.

A completed foreign account or asset statement if the information
on the statement was not already disclosed on the offshore voluntary
disclosure letter.

Completed penalty computation worksheet.

Signed extension of time to assess tax (including penalties and
FBAR penalties).

Completed FBARs.

For applicants disclosing offshore financial accounts with an
aggregate highest account balance in any year of $500,000 or more,
financial account statements showing all account activity during the
voluntary disclosure period. For applicants disclosing offshore
financial accounts with an aggregate highest account balance in any
year of less than $500,000, copies of offshore financial account
statements reflecting all account activity for each of the tax years
covered by the voluntary disclosure must be available upon request.

It should be noted that in most instances, the taxpayer will be
required to sit down with the IRS agent assigned to the taxpayer’s
case in a meeting that might also include a supervisor and an attorney
from the IRS District Counsel’s office.

FBAR VIOLATIONS OUTSIDE THE OVDI

If the IRS has already obtained a taxpayer’s foreign account
information from a foreign institution, he or she will likely be
barred from the voluntary program. In addition, there could be
strategic reasons not to enter the program.

The IRS will seek to determine whether the foreign account violations
were willful and, if so, whether the case is worthy of criminal prosecution.

Willful vs. nonwillful violations. This
determination is critical for the assessment of civil penalties.
Willful penalties, as described above, can be as high as the greater
of $100,000 or 50% of the account value. This is in addition to back
taxes, interest, and an accuracy penalty that is 20% (or in some cases
40%) of the back taxes owed. A nonwillful violation generally calls
for a penalty of up to $10,000 per year of violation for the years
that remain open under the statute of limitation. In some cases, the
IRS may agree to waive penalties altogether, though this appears to be
rare. So what separates a willful violation from a nonwillful
violation?

The test for willfulness is whether there was a voluntary,
intentional violation of a known legal duty (IRM §4.26.16.4.5.3.1).
The IRS has the burden of establishing willfulness (IRM
§4.26.16.4.5.3.3). Willfulness is shown by the person’s knowledge of
the reporting requirements and conscious choice not to comply. In an
FBAR situation, the only thing that a person needs to know is that he
or she has a reporting requirement. If a person has that knowledge,
the only intent needed to constitute a willful violation of the
requirement is a conscious choice not to file the FBAR (IRM
§4.26.16.4.5.3.5). Several examples of what the IRS considers to be a
willful violation can be found in IRM Section 4.26.16.4.5.3.8.

While the standard of proof the IRS must meet to prove that an FBAR
violation is willful formerly appeared to be one of clear and
convincing evidence (see IRS Chief Counsel Advice (CCA) 200603026),
the less strict preponderance-of-the-evidence standard was applied by
the court in McBride, No. 2:09-cv-378 (D. Utah 2012).

Willful violations are perhaps more likely to be found where the
account owner put the funds in the account, used the funds in some
manner, and actively participated in keeping the account hidden from
the authorities. Nonwillful violations may more likely be found where
the taxpayer did not put the funds in the account, exercised no
control over the funds, did not use any of the funds, and was unaware
of reporting requirements. Clearly, a large spectrum of behavior
between these two extremes comes down to the facts and circumstances
of a particular situation. Defending a client against the higher
penalties associated with willfulness calls upon the practitioner’s
skills and abilities.

Can a taxpayer avoid the finding of a willful violation by claiming
that he or she did not know about the foreign account filing
requirements? For a time, it looked as if one district court was going
in this direction (see Williams, No. 1:09-cv-437 (E.D. Va.
9/1/10)). On the government’s appeal, however, the Fourth Circuit held
(Williams, 489 Fed. Appx. 655 (4th Cir. 2012)) that the
district court had clearly erred in finding that Williams did not
willfully violate 31 U.S.C. Section 5314, the federal law that
requires individuals to report to the IRS annually any financial
interests they have in any bank, securities, or other financial
accounts in a foreign country.

In Williams, the taxpayer, Bryan Williams, checked “no” on
Schedule B, Section III, line 7a, and filed no FBARs. He claimed that
he was unaware of the filing requirements and never read the actual
words on his return. The Fourth Circuit found that the taxpayer made a
conscious effort to avoid learning about the reporting requirements.
The court found that signing his 2000 federal income tax return was
prima facie evidence that the taxpayer knew the return’s contents.
Williams’s false answers on both the tax organizer he filled out for
his tax preparer and his income tax return further indicated conduct
that was meant to conceal or mislead on sources of income or other
financial information, the court found. In such a situation, “willful
blindness” may be inferred, the court said, where “a defendant was
subjectively aware of a high probability of the existence of a tax
liability, and purposely avoided learning the facts” (quoting
Poole, 640 F.3d 114, 122 (4th Cir. 2011)).

According to the court, at a minimum, Williams’s actions established
reckless conduct, which satisfied the preponderance-of-the-evidence
burden of proof requirement for the civil FBAR penalty for willfulness.

McBride similarly dealt with willfulness in the context of
FBARs. The taxpayer, Jon McBride, had a company that was operating
overseas. He retained the services of a firm that designed strategies
to allow its clients to avoid reporting income and their ownership in
assets by having its clients’ assets held by nominees holding legal
title of shell corporations and foreign bank accounts. McBride
accessed the funds through sham lines of credit. The district court
found that McBride had an interest in foreign accounts and that he
willfully failed to report his interest in them.

By signing his returns, McBride was said to have imputed knowledge of
the requirement to file FBARs, since the tax returns contained a plain
instruction informing individuals that they have the duty to report
their interest in any foreign financial or bank accounts held during
the tax year. The court acknowledged that willful blindness satisfies
a willfulness standard in both civil and criminal contexts. In
McBride, the court also reasoned that the willfulness
standard can be satisfied through the taxpayer’s reckless disregard of
a statutory duty. Simply not knowing about the foreign account
reporting requirements is not enough to defeat a finding of
willfulness.

The court noted in McBride that subjective knowledge was not
required for the taxpayer to have willfully failed to comply with the
FBAR requirements, because the taxpayer acted in reckless disregard of
the known or obvious risks created by his involvement with foreign
accounts. Drawing an analogy with the trust fund recovery penalty
standards under Sec. 6672, the court stated that “a responsible person
is reckless if he knew or should have known of a risk that the taxes
were not being paid, had a reasonable opportunity to discover and
remedy the problem, and yet failed to undertake reasonable efforts to
ensure payment” (quoting Jenkins, 101 Fed. Cl. 122, 134 (2011)).

In the Williams and McBride cases, the courts noted
that both taxpayers failed to discuss their financial strategies
involving millions of dollars with their accountants. This was viewed
by the court as significant evidence of willfulness or at least
recklessness and willful blindness.

OPTING OUT OF THE OVDI

There might be good reason to opt out of the OVDI. To see some
examples that the IRS believes to be appropriate opt-out
opportunities, see Offshore Voluntary Disclosure Program Frequently
Asked Questions and Answers, Question 51.1, available at tinyurl.com/9oolgde. Opting out
is at the sole discretion of the taxpayer and is an irrevocable
election. Examiners are advised that taxpayers should not be treated
in a negative fashion merely because they choose to opt out.

Once an opt-out is elected, the taxpayer can expect a full audit. The
IRS will remind the taxpayer in writing of the continuing
responsibility to cooperate under Criminal Investigation’s Voluntary
Disclosure Practice and will instruct the taxpayer to provide a
written statement setting forth the facts of the case, a
recommendation of the penalties that should apply, and the rationale
for the penalty recommendations within 20 days of receiving the letter
from the IRS. (See IRS memorandum, “Guidance for Opt Out and Removal
of Taxpayers from the Civil Settlement Structure of the 2009 Offshore
Voluntary Disclosure Program (2009 OVDP) and the 2011 Offshore
Voluntary Disclosure Initiative (2011 OVDI)” (June 1, 2011).)

FBAR VIOLATION MEETINGS WITH THE IRS

Meetings with the IRS concerning FBAR violations create a quandary
for the practitioner. The IRS will generally not settle FBAR cases
without having a face-to-face meeting with the taxpayer. A taxpayer
who refuses is deemed to be uncooperative, and this may have an impact
on penalties (see IRM Exhibit 4.26.16-2 (7/1/08)). On the other hand,
if the attorney advises the client to attend the meeting and speak
freely, will a bad result raise a potential malpractice issue? If the
client is advised to not agree to the meeting, the IRS will move to
compel the meeting. While the IRS can ultimately force the client to
meet, it cannot force him or her to speak.

Now a choice must be made. One alternative is for the client to plead
the Fifth Amendment right against self-incrimination at such a
meeting, though doing so will almost certainly lead to greater IRS
scrutiny. If the client has a good story to tell, this is likely the
time to tell the story if there is a good chance that, based on the
facts, the practitioner thinks that nonwillful penalties are likely to
apply. If the client is going to speak at this meeting, he or she must
be candid and truthful.

This is yet another area where the practitioner’s experience and
judgment play a large role. This may be a good time for the client to
engage an attorney if he or she has not done so already. In any event,
the client must make the ultimate decision about whether to have the
meeting. All communications with the client on this topic should be in
writing, for the practitioner’s protection (see the sidebar,
“Checklist for Foreign Accounts,” for a step-by-step framework for
assessing the client’s circumstances and recommending a course of
action).Making a Clear Assessment of the Facts

Where a taxpayer was clearly willful or reckless, the voluntary
program may be the best option if the IRS has not found the taxpayer
before he or she attempts to enter the program. This tack will limit
penalties and likely help the client avoid criminal prosecution. But
where willfulness and recklessness do not appear to be the cause of
the reporting failures, careful consideration should be given to
opting out of the voluntary program.

The IRS can determine that no penalty is warranted and issue a
warning letter, though again, it rarely does. Rather, it will look to
determine if there was some level of negligence in a particular
matter. Negligence can be inferred in some instances by the
sophistication or education level of the taxpayer. With a large
account, $10,000 per year for each year that the FBAR statute of
limitation is open may be far more palatable than the penalty that
would be paid under the voluntary program. Another consideration is
that the FBAR examiner has a certain amount of discretion. The IRS has
developed penalty mitigation guidelines to ensure some level of
consistency in the treatment of similarly situated taxpayers.

According to IRM Section 4.26.16.4.6.1, to qualify for mitigation, a
person must meet four criteria:

The person has no history of criminal tax or BSA convictions for
the preceding 10 years, as well as no history of past FBAR penalty assessments.

No money passing through any of the foreign accounts associated
with the person was from an illegal source or used to further a
criminal purpose.

The person cooperated during the examination.

The IRS did not determine a civil fraud penalty against the person
for an underpayment of income tax for the year in question due to
the failure to report income related to any amount in a foreign account.

There is a risk of criminal prosecution when a taxpayer has a hidden
offshore account. This is another reason to consider engaging an
attorney early in the process. In terms of criminal prosecution and
incarceration in offshore cases, it appears that judges are handing
down shorter sentences than recommended under federal guidelines, with
the average sentence being about half as long as in some other types
of tax cases.

Since Treasury and Justice began their heightened scrutiny of
offshore account activity roughly four years ago, they have charged at
least 71 taxpayers criminally. The average sentence handed down in
offshore cases has been less than 15 months. In contrast, the average
sentence in tax-shelter schemes has been 30 months over the past three
years. Three-quarters of taxpayers charged in offshore account cases
have pleaded guilty. Prison sentences have been handed down about half
the time (see “Leniency for Offshore Cheats,” Wall Street
Journal, May 5, 2013).

AN EVER-WIDER NET

The IRS will continue to develop its capabilities in finding and
prosecuting foreign account cases. The new agreement with the Swiss
and the fact that the IRS insists on interviewing taxpayers indicates
that there is a high risk that foreign banks and taxpayers will name
others involved in foreign account facilitation, thus allowing
Treasury and Justice to cast an ever-wider net. An adviser must look
at the facts of each case and determine which path to suggest to a
client, because doing nothing is no longer a viable option.

Checklist for Foreign Accounts

Initial inquiry:

Does the client have a foreign account?

If yes, is it the type of account that is covered by 31 U.S.C.
Section 5314?

If applicable, has the client properly completed Form 1040,
Schedule B, Interest and Ordinary Dividends, Part III, Line 7a?

Has the client filed Form 8938, Statement of Specified Foreign
Financial Assets, with his or her federal income tax return?

Has the IRS already contacted the client about the foreign
account?

For a client with an unreported foreign account who has not
been contacted by the IRS:

How long has the client had the account?

What was the source of the funds?

Was the account inherited?

Did the client use funds in the account or actively manage it?

Is the client a nominal or beneficial owner of the account?

Does an entity own the account? If yes, what is the client’s
ownership of or involvement in the entity?

Upon your analysis, does it appear reasonably likely that the IRS
could sustain a successful criminal prosecution against the client?

Upon your analysis, does it make sense to enter the Offshore
Voluntary Disclosure Initiative (OVDI)?

Despite the risk, is there logic in considering a quiet disclosure
rather than entering the OVDI?

Is there a reason to opt out of the OVDI?

Are there other issues on the client’s federal income tax return
that would not stand up to an IRS audit?

Additional considerations when the client has been contacted
by the IRS or is denied access to the OVDI:

Has the client disclosed the account to his or her accountant or
tax preparer?

Does it appear that the IRS could sustain a willfulness penalty
against the client?

Do the facts support a negligence penalty?

Do the mitigation guidelines apply?

EXECUTIVE SUMMARY

Taxpayers with an interest in or signature authority over
foreign accounts generally must disclose them on their
annual tax returns and file FinCEN Form 114 (formerly TD F 90-22.1),
Report of Foreign Bank and Financial Accounts (FBAR), with the
Treasury Department annually by June 30.

The IRS is increasingly likely to detect
noncompliance as it gains greater cooperation from foreign
financial institutions and analyzes returns for new and “quiet”
disclosures. Qualifying taxpayers wishing to limit their exposure may
enter the IRS’s Offshore Voluntary Disclosure Initiative (OVDI).

If taxes on income from undisclosed foreign accounts is
unpaid, taxpayers in the OVDI will likely pay eight prior
years’ back taxes on the income, plus a 20% accuracy penalty, and an
additional penalty of 27.5% of the highest account value. In return,
they will not be subject to criminal prosecution or liable for the
potentially much greater penalties that could be imposed, especially
if the noncompliance is willful.

However, some clients may be best advised to opt out of the
OVDI if, for instance, they have unreported foreign account
income but no tax deficiency, and in some instances, for nonwillful
failure to file FBARs.

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